Dewey’s dragooned capital

The fallout from the Dewey and LeBoeuf’s bankruptcy continues to be bizarrely fascinating. The latest question: did Citibank intentionally withhold information about Dewey’s finances to get new partners to help pay down the firm’s debt? And when does a lender have any fiduciary duty to a borrower?

Citibank sued Steven Otillar, a former Dewey partner, in the immediate aftermath of the firm’s collapse for defaulting on a $207,000 loan (full court filing here). Otillar borrowed the money because he had to pay Dewey when he joined as a partner. Citi’s loan wasn’t one-off, but part of an ongoing program between the bank and Dewey. Here’s the American Lawyer’s explanation:

Citi launched a capital contribution program with Dewey in 2010, according to former partners, through which it offered six-year loans—with Dewey paying the interest for the first three years—to help partners fulfill capital obligations that committed them to contribute 36 percent of their targeted yearly compensation to the Dewey partnership by the end of the calendar year in which they joined.

Dewey was a private partnership, and as bankruptcy lawyers and Mad Men fans know, that means partners are on the hook for capital contributions to the firm. That’s cash which partners are occasionally required to hand over in order to remain members of the partnership.

Think of capital contributions like very expensive club fees that can come due at anytime. And because they’re generally called on at times of distress, they tend to correspond to low points in individual partner’s enthusiasm or ability to pay. That’s why the Citi loan program was attractive to new partners.

This is clever stuff — Dewey got to refinance a portion of its debt using capital from its partners, each of whom could conveniently borrow the cash from Citi, with Dewey paying all the interest. The partners’ contributions were a condition of their job offer. And Citi was ready to step in with loans as soon as Dewey dragooned the commitments from its new hires. So Dewey gets a valuable asset (a new partner), that new partner pays upfront for the privilege, and that cash helps Dewey pay down its debt. The upside for the new partner is a potentially large future income stream. Also, under the terms of the loan from Citi, if the new partner left Dewey, Dewey would repay the loan and give the ex-partners their money back within three years. But I’d wager there were sufficient conditions attached to this offer to make it pretty unattractive to leave the firm once you’d gotten your loan from Citi.

As the American Lawyer notes, Citi has a lending relationship with Dewey that goes back to the 70s, and the bank participated in a $100 million line of credit Dewey received earlier this year. More specifically, Reuters’ Casey Sullivan reports that Citi “issued some of Dewey’s management team letters of credit securing management’s compensation in the event of the firm’s collapse”. The letters of credit meant that if Dewey did in fact go under within a specific period of time, Citi would pay management’s comp. Of course, management paid a fee for this service and it’s not the kind of agreement anyone would enter into under rosy circumstances. Citi would also want to figure out how likely management was to draw on these letters of credit. That is, how likely it was that Dewey might go bankrupt. In the end, the letters of credit expired before Dewey did, so they’re not important themselves.

What is important is what Citi may have learned or inferred when it issued the letters of credit. Otillar claims that in the process of issuing the letters of credit, and presumably examining Dewey’s financial health, Citi acquired a fiduciary duty to disclose what it knew to Otillar. As a general rule, lenders don’t have any fiduciary responsibility to borrowers. But Otillar says Dewey management’s request for the the letters of credit was a clear indication to Citi that Dewey was in distress and that the bank had a duty to disclose any knowledge of Dewey’s financial troubles to him before making that $207,000 loan. But why would Citi, or any other bank, make a loan if there was clear doubt the loan would be paid back?

A good reason might be that if bankruptcy occurred, Dewey’s individual partners would be easier to collect from than Dewey the corporate entity. The way these loans to partners are typically recovered in a bankruptcy, as Sullivan notes, is through a compromise between the banks and the individual. In other words, the bank takes a haircut. But a quicker and more advantageous one than it might get through the corporate bankruptcy process.

That might be clever risk management, but it doesn’t seem like it creates, or breaches, a fiduciary duty. Unless there are blockbuster documents showing that Citi knew Dewey was doomed, it’s hard to see how Otillar will be able to overcome the argument that it was his right and responsibility to inspect the firm’s finances before investing. Any moderately experienced executive should have the smarts to get a sense of a company’s financials before taking a portion of their pay in equity.

But the odder question is still unanswered. Why, out of hundreds of former Dewey partners, is Otillar the only one being sued? Why not just hash out the haircut and move on?